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PIMCO’s 3 Ways to Fight Inflation

PIMCO portfolio manager Mihir Worah said he and other analysts at the bond shopexpect global inflation to be higher in the next few years than it has been over the last 20 years.

“While we do not expect double-digit inflation, we do see inflation gradually climbing higher than the close-to-2% core numbers that we have gotten used to in much of the developed world,” Worah (left) wrote in a report that PIMCO released Monday.

As a result, the portfolio manager has several suggestions on how investors (and advisors) can position client assets for such a development.

Worah say there are two main reasons to expect higher inflation in the next three, five or 10 years. “First, in developed markets, there is a serious debt problem, and it is going to be hard for developed countries to grow out of it. Inflation is one of the only 'solutions' that we see as likely to occur,” he said.

The emerging markets, though, have been a force of disinflation, the portfolio manager says. But while they have exported goods and services at very low prices in the past, PIMCO sees that changing in the future.

“Estimates vary, but the middle class in emerging markets could expand by about 2 billion people over the next two decades, and that means commodity-intensive uses could increase—as people move from mud to concrete, buy washing machines, cars and more,” wrote Worah, who has been in the investment field for more than 10 years and holds a doctorate in theoretical physics.

As a result, PIMCO expects there to be “a secular rise in global commodities prices—with some cyclical dips—contributing to global inflation,” he said. “A more indirect contributor to inflation could come in the form of emerging markets reaching a limit to the productivity ‘miracle,’ and that potentially translating to higher production costs and, ultimately, higher export prices.”

In addition, the U.S. dollar could decline against currencies in higher-growth regions, which would be inflationary, the portfolio manager notes.

Portfolio Positioning

Worah believes that thinking about inflation and structuring portfolios to help guard against high inflation “should be a central element of any investment strategy.”

To hedge inflation risk, he recommends three types of assets.

“The core asset, in our view, is developed market inflation-linked bonds (ILBs), such as Treasury inflation-protected securities (TIPS) in the U.S,” he wrote. “We believe these should be the bedrock of any inflation hedging strategy—‘the money under the mattress,’ with principal backed by the full faith and credit of the U.S. government.”

Though these bonds may offer modest returns, if they’re held until maturity, their real returns are known since the payments are explicitly linked to inflation, Worah says.

A second allocation should be considered in slightly more volatile assets in order to seek potentially higher returns. This means allocating a certain percentage of a portfolio in real assets, such as commodities, dividend-yielding equities and real estate investment trusts (REITs).

A third investment could be made in inflation-linked bonds issued by emerging-market countries, like Mexico and Brazil. Look for nations with a strong fiscal balance sheets and bonds that have the potential for relatively attractive after-inflation rates of return, he suggests.